Opinion

No rescue party: Trump and Wall Street have been sent an ice-cold warning

By Ambrose Evans-Pritchard

May 24, 2019 — 10.11am

The US Federal Reserve has sent markets a sobering message. It will not bail out the Trump administration as the trade war expands; nor will it come to the rescue quickly if Wall Street wilts.

Markets have sent a blunt warning by the Fed. Credit:AP

The proverbial "Fed Put" is a long way out of the money at this juncture. The outlook for the US economy will have to take a nasty turn before the Powell Fed cuts interest rates or halts quantitative tightening altogether.

"The hurdle for cuts is very high," said Tom Porcelli, US strategist for RBC Capital and a former Fed official.

The Fed minutes released late on Wednesday are something of a shocker for investors who thought they had a monetary comfort blanket for the rest of this year. Futures contracts show markets have been pricing in 50 basis points of rate cuts.

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The text revealed that "many" members of the voting committee had dismissed the recent soft patch in inflation as "transitory" and largely caused by "idiosyncratic factors". This amounts to a warning by the world's hegemonic central bank that it may raise rates. It is an ice-cold douche for fragile markets.

The Shanghai composite index is now down 15 per cent from highs just a month ago. The MSCI index of emerging -markets is off almost 11 per cent. Secondary fallout is starting to reach Europe. "A rising dollar tightens global funding conditions," said Hans Redeker and Gek Teng Khoo from Morgan Stanley. Offshore dollar loans and bonds have reached $US12 trillion ($17.4 trillion) with further liabilities hidden in derivatives, according to the Bank for International Settlements.

Morgan Stanley said it is "increasingly bearish" as dollar liquidity dries up, warning financial markets have become unhinged from fundamentals. It has advised clients to retreat to the safe haven of the Japanese yen.

Much of the dollar debt is owed by Asian, Latin American, and Middle East corporations. It is often on short-term maturities - typically three months - and has to be rolled over at a higher cost on offshore funding markets as the dollar creeps up. The Fed's broad dollar index is testing a 17-year high.

US Fed chairman Jerome Powell has some big decisions ahead.Credit:Bloomberg

"We are going to get a crisis and when that happens the capital flows will reverse," said William White, the BIS's former chief economist.

"It reminds me of what happened in 2008 to 2009 when European banks were -financing long-term assets in the US with short-term dollar debt. They had a huge liquidity problem. This time the trouble is in Asia, and I am afraid that Asian banks might have to sell a lot of assets in fire-sale conditions."

The Fed saved the day in 2008 by -extending emergency dollar liquidity to fellow central banks through swap lines. "It is not clear whether Trump and Congress would let the Fed do that again," said Professor White. "They think it is lending trillions to untrustworthy foreigners."

What is raising eyebrows is the continued fall in the Chinese yuan. It has been sliding relentlessly over the last three weeks as relations between Washington and Beijing reach rupture. The yuan hit Y6.92 to the dollar yesterday. The Chinese authorities have -defended this level in past episodes but there is concern this time that they may let the exchange rate break through the psychological line of Y7 - perhaps judging it too risky to squander foreign -reserves trying to defend the currency. China's $US3 trillion reserves are not as big as they look under the International Monetary Fund's adequacy rule.

Hong Kong regulators say foreign funds have been withdrawing money from the Chinese mainland at a torrid pace through the Shanghai-Hong Kong Connect pipeline. The net exodus has been $US42bn so far in May. "Steady -inflows have converted into sharp outflows," said Mr Redeker.

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Chinese companies have also been scrambling to raise dollars pre-emptively to cover $900bn of hard currency debt. It is possible that China is orchestrating a stealth devaluation in order to claw back trade competitiveness and retaliate against the US. Any evidence that China is deliberately steering down its currency would further -enrage President Donald Trump.

Mr Redeker said such manipulation is highly unlikely. Beijing was traumatised by the exchange rate scare in 2015-2016 when the People's Bank burned through $1 trillion of reserves trying to hold the line. The authorities will probably defend the exchange rate aggressively if turbulence sets in.

Mr Porcelli said the Fed is right to take a tough stand on rates. It is faced with "super tight labour markets" and capacity constraints in the US. There is a risk that cost-push inflation will become lodged in the system. The Fed may have to raise rates regardless of mounting stress in the rest of the world.

The Fed's message to Trump is: We will not bail out your administration as the trade war expands.Credit:AP

Yet the voting committee is starkly divided. Doves fret that the greater danger is a lurch downwards for the economy as Mr Trump's fiscal stimulus fades and the profit cycle rolls over.

They fear a repeat of mistakes made last December when the Fed misjudged the severity of the global trade slowdown and raised US rates into the teeth of a market squall. The Fed was quickly forced to make the most dramatic policy about-turn since the late Nineties.

The US data is sending a blizzard of mixed signals, as often happens at key turning points in the cycle. Consumer optimism is running high and truck tonnage soared 7.4 per cent in April.

Yet trade wars have begun to hit capital expenditure by companies. Major appliance shipments in the US fell 17 per cent last month from a year ago, comparable to falls seen during the onset of the subprime crisis in 2008.